02/24/2011

C-Suite Pressure

There is an old saying that “money is the root of all evil.” But recent research shows that the motivation for some CFOs to become involved in material accounting manipulations has less to do with money than it does with pressure from the CEOs in their companies.

These educators used a comprehensive sample of material accounting manipulations disclosed between 1982 and 2005 to investigate the costs and benefits associated with intentional financial misreporting for CFOs. What their research shows is that CFOs are typically not the instigator of accounting manipulations. Instead, CEOs, especially powerful CEOs who have high equity incentives, exert tremendous influence over CFOs’ financial reporting decisions. So the CFOs are responding to this CEO pressure more than they are seeking immediate financial benefit. As a result, the CFOs’ role as watchdog over financial reports is compromised by this pressure from CEOs.

Not all CFOs succumb to this pressure though. The research also shows that there is a significantly higher CFO turnover within three years prior to the occurrences of material accounting manipulations for manipulation firms compared to control firms. So some CFOs are saying no to the pressure and leaving the company rather than fudging the numbers.

The overall findings of the study suggest a corporate governance failure and have implications for corporate governance reform. While many commentators have placed a focus on stock-based compensation and its effect on CFOs misstating accounting numbers, this research suggests that re-designing compensation packages for CFOs is not the only answer. Improving CFO independence by limiting the pressure of CEOs on CFOs could also improve financial reporting quality. One possible way to achieve that might be to have boards or audit committees more involved in the CFO performance evaluation and in hiring and retention decisions for CFOs.

What the study also shows is the real challenge that CPAs who serve as CFOs face as they carry out their responsibilities. While professional ethics provides the guidance and shows the pathway to follow, CFOs are the ones making this journey on their own and sometimes they succumb to the pressures exerted within the company. Being ethical when there are no challenges is easy. It’s when the heat is on that the real test of ethical behavior takes place. Thankfully, the vast majority of CPAs choose the right path. But maybe there are changes that can be made within the corporate governance system to give them some additional support.